The financial accounting term working capital is used to describe the excess of current assets when compared to current liabilities. The relative size of a company’s working capital is an indication of the short-term financial strength of the company.
Working Capital = Current Assets – Current Liabilities
A company with adequate working capital can carry the appropriate level of inventory, make purchases in bulk, and sell to customers on favorable credit terms. Working capital allows a company to pay its debts as they come due. Companies can be forced by creditors to liquidate assets if working capital is inadequate.
Working capital can be determined by subtracting current liabilities from current assets, both of which can be found on the company’s balance sheet. Current assets are those resources that can be converted into cash in less than 12 months. Current liabilities are the debt of the company that must be settled in cash over the next 12 months.
The current ratio is calculated as current assets divided by current liabilities. Therefore, working capital will be a positive value when the current ratio is greater than 1.0. Creditors like the current ratio to be greater than 2.0, which would mean current assets would be twice current liabilities.
Company A’s balance sheet indicates total current assets of $12,240,000 and total current liabilities of $5,441,000. The working capital for Company A would then be:
= $12,240,000 – $5,441,000, or $6,799,000